As if Tenants didn’t have enough to worry about, soon they will have a new accounting regulation with which to comply. It is known as Capital Lease Accounting. The lease accounting changes will not affect the underlying leases, but it will requireTenants to recognize the total expense obligations of their leases as liabilities on their Balance Sheets. Not only will balance sheet ratios be affected, but just getting to the correct entries will require tedious calculations by the Tenant.
Some have questioned whether this is yet another another mean-spirited regulation of government. Yes, it is a regulation (sort of), but it is not the government. The instigator of this initiative is the Financial Accounting Standards Board (FASB). FASB is the U.S. organization that forumlates accounting standards domestically. Internationally, a sister organization known as IASB (International Accounting Standards Board) forumulates accounting standards for the IFRS. Confused yet? The key point is that international standards have long required that lease obligations be recognized on Balance Sheets. In the U.S., most lease liabilities have NOT been on the Balance Sheet. Rather, the “straightline” rents have merely been reflected on the Income Statement as an expense. Internationl pressures together with the Enron and Worldcom fiascos of the early ’90′s have changed that. Since 2006, FASB has been wrestling with how to implement a satisfactory solution to achieve greater transparency and international conformity.
As drafts of the change were circulated for review, many business owners and executives worried that the reporting would unduly penalize companies because of the proposed application of the regulation. The concern was that lease obligations would be front-loaded due to the calculation. Business leaders argued that rent payments tend to be relatively flat or grow modestly over the term of lease. Front loading would would portray an unrealistic picture of the indebtedness. It turns out that with some arm twisting, both the FASB and IASB agreed. They carved out a modified approach for real estate leases. A decision was reached to allow most real estate leases to avoid the sqewed front end liability. The same is not true for equipment leases, but that is a different discussion.
So what’s next? The new rules will likely be put into effect sometime in 2013. There will be NO Grandfathering. Tenants will need to comply with the new standards in the year of implementation even if they are mid-term in an existing lease term. The impact will be greater for public companies; they will be further required to restate the prior two years financial statements to reflect the impact of the change as if it had happened previously.
Stay tuned for more information on Capital Lease Accounting and what it means to you.